Breakingviews - Brexit dividend will be cashed in euros

LONDON (Reuters Breakingviews) - Economic reality is intruding on the political debate over Brexit. Two years after Britain voted to quit the European Union – and nine months before it is formally due to leave the bloc – the terms of its departure remain undecided. Prime Minister Theresa May’s latest plan, which she is due to debate with her cabinet on Friday, will not give companies the clarity they seek. It’s even harder to see how Britain’s financial sector benefits from a supposed “Brexit dividend”.

On Thursday Jaguar Land Rover said the introduction of tariffs or other trade frictions with the EU would force Britain’s biggest carmaker to slash investment in the United Kingdom. Industrial groups Airbus, Siemens and BMW have also warned of supply chain disruption. These are not just hypothetical admonitions.

The UK’s automotive lobby estimates investment in the industry halved in the first six months of 2018 year-on-year. Ferrovial, the Spanish group which operates London’s Heathrow Airport, is moving its international holding company from the British capital to Amsterdam. The London Stock Exchange and Chicago’s CBOE Global Markets are opening trading venues in the Dutch city.

Yet corporate demands for clarity are largely futile. Even if cabinet ministers gathering at May’s Chequers country residence back her convoluted plan for a “facilitated customs arrangement”, this will only serve as a starting point for EU negotiations. Assuming the two sides then reach an agreement, the British and European parliaments must still approve it. Even then, many details will not be finalised until after Britain leaves in March 2019. Meanwhile the risk of what Bank of England Governor Mark Carney calls “a disorderly cliff-edge Brexit” remains. Indeed, May last month fought off a parliamentary rebellion that effectively sought to take away that option.

The unease is weighing on economic activity. John Springford of the Centre for European Reform estimates the UK economy is 2.1 percent smaller today than it would have been without the adverse shock caused by the Brexit referendum. A recent survey of 600 euro zone companies by UBS analysts shows that 35 percent expect to reduce investment in Britain, and 41 percent plan to move a large amount of capacity out of the country.

If May can secure a deal that minimises customs frictions and keeps Britain closely aligned to the rules of the EU’s single market, trade in physical goods should continue relatively unhindered. Any changes will not be implemented until a transition period ends in 2020 – and that deadline may slip further.

Yet an agreement for frictionless trade of goods will not help Britain’s financial services industry. Barring a sudden change of direction, London-based banks, brokers and insurers will lose the “passport” that allows them to offer their products across the EU. A plan by Philip Hammond, Britain’s chancellor, for a broader regulatory partnership has received little EU support.

Under pressure from regulators, banks are assuming Brexit occurs in March 2019. They have set up subsidiaries, secured office space, and even started moving staff to Frankfurt and Paris.

So far, the number of jobs moving out of London is limited. Continental units are ill-equipped to cope with a large influx of business: the London subsidiary of one Wall Street bank has a balance sheet 500 times larger than its EU-based unit. British regulators have also eased the pressure by allowing continental bank subsidiaries to operate through branches in London.

Yet maintaining multiple subsidiaries is inefficient. Deutsche Bank analysts estimate shifting EU exposures out of London would force banks to set aside 35 billion to 45 billion euros in extra capital. Booking loans and other trades in multiple subsidiaries forces banks to manage separate repositories of risk. The benefits of matching and cancelling out opposing derivative exposures – a process known as netting – are diminished.

Banks can get around these issues by transferring risk from units in Frankfurt or Paris through offsetting “back-to-back” trades with London. Yet that still means higher capital and liquidity requirements for inter-company exposures. Moreover, the European Central Bank has said it will not permit London-based groups to set up “empty shells” in the EU. The European Banking Authority has told banks and insurers not to assume that existing contracts will be valid in the event of a chaotic Brexit. The message is that, over time, business will have to shift.

In the longer run EU regulators – stripped of UK influence – will have further reasons to tilt the regulatory playing field away from Britain. Authorities have so far failed to shift clearing of euro-denominated derivatives out of the City, or to prevent London-based managers from overseeing European funds. But the intent is clear.

Any soft Brexit deal can only mitigate these costs, not reverse them. That reality – and the continued risk of a chaotic outcome – ensures that May’s Brexit dividend is more likely to be cashed in Europe.

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